UU Investing - Motilal Oswal · 12/15/2010 · 15th Annual Wealth Creation Study 5 Evolution of...

UU Investing

Creating wealth from the unknown and unknowable

By Raamdeo Agrawal

December 15, 2010

www.motilaloswal.com 15th Annual Wealth Creation Study 2

Theme 2011

UU Investing

Creating wealth from the unknown & unknowable


• UU Investing is investing in the unknown &

unknowable (UU i.e. the “world of ignorance”)

• What is UU? = Situation where future states of the

world are unknown

• UU investing = the art of “selecting assets that

will fare well when future states

of the world become known.”

What is UU Investing?

”

“ The real world of investing

often ratchets the level of non-

knowledge into still another

dimension, where even the

identity and nature of possible

future states are not known.

This is the world of ignorance.


• 3 states of the world – Known (K), Unknown (U),

Unknown & Unknowable (UU)

Understanding K, U and UU

Understanding UU

”

“ The real world of investing

often ratchets the level of non-

knowledge into still another

dimension, where even the

identity and nature of possible

future states are not known.

This is the world of ignorance.

Knowledge of

outcomes

Investment

environment

Stock market relevance

Known

(Risk)

(K)

Outcomes known;

Probabilities known

Distribution of returns known Not very relevant; very

few outcomes have

known probabilities

Unknown

(Uncertainty)

(U)

Outcomes known;

Probabilities

unknown

Distribution of returns

conjectured

Faced by all stock

market investors

Unknown &

Unknowable

(Ignorance)

(UU)

Outcomes unknown;

Probabilities

unknown

Distribution of returns

conjectured

Complementary (i.e. special)

skills rewarded

Profitably exploited

ONLY by intelligent

investors


Evolution of stocks – from UU to UK to KK

Evolution of investor – from KK to UK to UU

UU Investing in stock markets

• When the future is broadly a

continuity of the past, it

becomes knowable through

research and analysis.

• When the future is

discontinuous from the past,

it enters the realm of the

unknowable, and calls for

unusual judgement, courage

and patience.

Unknowable Key investing skill:

Unusual judgement

Returns:

Omega

Key investing skill: Key investing skill:

Knowable Information access Research and analysis

Returns: Returns:

Market performance at best Alpha

Future -

discontinuous

null set

Facts

to date

Known Unknown

Future -

continuousEvolution

of

sto

ck

s

Evolution of investor


Past examples of UU investing

UU

UK

KK












• In the traditional investing model, portfolio return in

excess of benchmark is called "Alpha".

• We call the very high excess return possible from UU

situations “Omega”.

UU investing for Omega returns

”

“

There are systematic ways to

think about unknowable

situations. If these ways are

followed, they can provide a

path to extraordinary

expected investment

returns. UU investing returns

(omega)

Returns

Traditional investing returns

(alpha)

Market-linked

returns (beta)

Time

Omega

Alpha


Step 1: Know UU Success Principles (SPs)

Step 2: Look out for UU situations

Step 3: Be aware of the pitfalls

How to go about UU investing

”

“ Clear thinking about UU

situations, which includes prior

diagnosis of their elements, and

relevant practice with

simulated situations, may vastly

improve investment decisions

where UU events are involved.


SP #1: High asymmetric payoff

Step 1: Know Success Principles

”

“

The opportunity to get a 10 or

100 multiple on your

investment as often as you lose

virtually all of it is

tremendously attractive.

500% Payoff

UU

400%

300%

Uncertainty Positive payoff

200%

Risk 100%

Risk

Uncertainty

UU

Special skills

Negative payoff -50%

-100%

• Higher the challenge, higher the payoff

• Higher the skill, higher the upside payoff, lower the downside

payoff

• Unlimited upside, downside capped at 100%


SP #2: High level of complementary skills

• Domain knowledge of specific businesses

• Past experience elsewhere (in other companies,

in other industries, or in other geographies)

• Management assessment

• Imagination and unusual judgement

• Conviction and courage to commit the

investment


”

Alas, few of us possess the skills

to be a real estate developer,

venture capitalist or high tech

pioneer. But how about

becoming a star of ordinary

stock investment? For such

efforts an ideal complementary

skill is unusual judgment.

“


SP #2: High level of complementary skills (continued)

With complementary skills, the investor moves from

Quadrant C to Quadrant D, earning healthy returns


”

Alas, few of us possess the skills

to be a real estate developer,

venture capitalist or high tech

pioneer. But how about

becoming a star of ordinary

stock investment? For such

efforts an ideal complementary

skill is unusual judgment.

“

Easy for Others to

Estimate

Hard for Others to

Estimate

Easy for you

to estimate

A. Tough markets;

no excess returns

D. Benefit from the

UU situation using

special skills

Hard for you

to estimate

B. Avoid action;

possibility of

significant loss

C. Potential UU

situation



SP #3: Portfolio approach to diversify risks Initial Portfolio

Healthy final portfolio

despite low stock

success ratio

1 1 1 1 1

5

Stock A Stock B Stock C Stock D Stock E Portfolio

Year 0

0.25 0.50 0.75

12.5

510

1

Portfolio

Year 0

Stock A Stock B Stock C Stock D Stock E Portfolio

Year n

Portfolio up 2.5x



If none of your investments

looks foolish after the fact, you

are staying too far away from

the unknowable.

“ SP #4: Non-aversion to hindsight criticism

• Non-aversion to hindsight criticism is the core

behavioral principle.

• UU portfolio may offer healthy returns, but several

individual ideas would perform very poorly.

• This creates room for hindsight criticism of these

investment decisions.

SP #5: Long-term outlook and patience • To allow for the UU situation to play out into KK

and for the positive upside to pay off

With time and patience, the mulberry becomes silk.

— Chinese proverb

”


Step 2: Look for UU situations

Unknowable situations are

widespread and inevitable

“ • Where the future is discontinuous from the past

• In 3 areas: (1) Business (2) Management (3) Valuation

1. Business UU situations

Low history of industry and/or company

Huge size of opportunity with scalability

Technology intensity of business

Change (or scope for change) in regulation

Value migration

Demand J-curve inflexion point

Change in competitive landscape

Turnaround

Discontinuous corporate action

Discontinuous change in operating metrics

”


Step 2: Look for UU situations

2. Management UU situations

Management with no track record

Change in management

Integrity issues with management

3. Valuation UU situations

Extreme pessimism and optimism in the markets

creates UU situations e.g.

Infosys valuation at the height of dotcom boom

Indian stock valuations at the height of global

crisis in early 2009.

If the events are

unpleasant, it is not clear when

to celebrate their end.

“

”


Step 3: Be aware of pitfalls

1. Overconfidence

“If you lack Buffett capabilities, you will get chewed

up as a bold stock picker.”

2. Hindsight criticism

“One might be blamed for a poor outcome if one

invests in ignorance when, in fact, it was a good

decision that got a bad outcome.”


NTD to TTS Indian Banking Sector: Stocks for 2020

• UU situation: Which bank(s) will deliver superior

stock returns through 2020

• Complementary skills: Clear NTD framework

UU Investing case study


• Size of opportunity: TTS by 2020 - Ten Trillion Saving

(in dollars, decadal cumulative), 5x last decade

Huge opportunity for financial intermediation

NTD to TTS


• Asymmetric payoff possibility: - Banking sector profit in 2020 will be 6x 2010

Growth will be even higher for banks with UU potential

NTD to TTS

2010 to 2020 – Business up 5x … and profit up 6x


• Which stocks to bet on?

Judgement based on several factors including –

Value migration from PSU to private banks

Impact of technology on various banks

Assessment of bank managements

Past profitability analysis

So, the final unusual judgement? …

NTD to TTS

Sh

are

of

Assets

80 75 74

613 15

0%

20%

40%

60%

80%

100%

FY01 FY05 FY10

New pvt banks

Old pvt banks

Foreign banks

PSU banks


The Final Judgement

1. Buy a small/medium high growth bank – YES BANK

Management with established credentials

Growing at 2x industry growth rate

Branch scale-up plans to increase CASA; expand NIMs

Not among the cheapest banks, but absolute market cap

low compared to size of opportunity and that of peers

2. Buy a large, unpopular bank – CENTRAL BANK

Among top 10 banks by asset size

Recently completed 100% CBS; benefits to accrue

Management focus on margin improvement through

focus on high-yielding retail segment

Not among the cheapest in terms of P/B, but very

attractive in terms of MCap/Assets.

So, the final Alpha, Beta, Omega picture?

NTD to TTS


The Final Picture

NTD to TTS

UU investing (omega)

Central Bank, Yes Bank

Returns

Traditional investing (alpha)

SBI, HDFC Bank

Market-linked (beta)

Bankex

Time

Omega

Alpha


• Metals/Mining sector has dominated this year’s Study.

• Low payback ratio (Market cap/Next 5 years’ profits)

remains the most reliable indicator of fastest wealth

creation.

• UU situations offer asymmetric payoffs; these can be

exploited only by investors with complementary skills,

unusual judgement, and no fear of hindsight criticism.

• India’s high linear economic growth will create

exponential business situations – the perfect backdrop

for UU investing.

• TTS – Ten Trillion Dollar Savings through 2020 –

will throw up many UU investing opportunities in

Indian financial services.

In Conclusion


Wishing you exponential returns in exponential times

with UU investing!

Thank You & Happy Wealth Creating !!

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UU Investing - Motilal Oswal · 12/15/2010 · 15th Annual Wealth Creation Study 5 Evolution of...

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